The Mystery Of The Rising Nikkei

Overnight, the Nikkei fell as the yen strengthened.

Which is, generally speaking, what’s to be expected.

In fact, it’s not just that we “expect” the yen and the Nikkei to move opposite one another, we’ve come to “know” it. It’s as close to a truism as you can get in markets and with YCC enhancing USDJPY’s correlation to Treasury yields, the whole dynamic is becoming to a certain extent self-reinforcing.

As SocGen’s Kit Juckes wrote early this morning, “the correlation between USD/JPY and US Treasury yields remains stupidly strong [and] the causation seems clear enough – the BOJ is anchoring Japanese yields and the relative appeal of the yen is a function of yields overseas, encapsulated by the global bellwether.”

YenTreasurys

But lately, a funny thing has happened. I think I mentioned this the other day, but the Nikkei has become disconnected from the yen and thereby from Treasury yields. Have a look:

NikkeiUSDJPY

NikkeiUSD10

Bloomberg’s Cameron Crise thinks this may be a misnomer or, more accurately, he thinks a “dumb” overlay chart probably doesn’t tell the whole story.

In the piece excerpted below, Crise endeavors to paint a more complete picture but I think we’ll be forgiven for suggesting that perhaps the explanation has something to do with this

SocGenBOJ

Via Bloomberg

It often feels like the Nikkei and USD/JPY are joined at the hip, so the resilience of Japanese stocks amidst the recent weakness of the dollar has raised a few eyebrows. I decided to take a look to see if the Nikkei is as overvalued as a naïve overlay chart would have you believe. The reality is that Japanese stocks have performed generally as expected, but may still be in for a bout of further weakness.

  • The strong correlation of USD/JPY and the Nikkei is a well-known phenomenon — so much so that it impacts the relative pricing of yen- and dollar-denominated Nikkei futures. When the fortunes of the two diverge, as they have recently, the market takes notice.
  • It’s tempting to conclude that the Nikkei is overvalued based on its outperformance, but reality is generally more complicated than an overlay chart suggests. To get a better sense of Nikkei valuation, I built a simple model to explain changes in the index.
  • Specifically, I modeled 13-week (i.e., 3 month) changes in the Nikkei using three explanatory variables: the equivalent changes in USD/JPY, trailing Nikkei earnings, and the S&P 500. The fit was surprisingly good, with an r-squared of 0.62 since 2002. I ran a separate regression using data since 2014; the coefficients were broadly similar and the fit was even better, with an r-squared of 0.72.
  • In the three months ending last Friday, the Nikkei had rallied 3.6%. While this was more than the modeled decline of 1.2%, the divergence isn’t particularly notable by historical standards (representing 0.7 standard deviations). Moreover, the gap has only opened over the last week or two.
  • Although the model was built solely as an explanatory mechanism, it does appear to contain some forward- looking information as well. I generated weekly trading signals from the divergence between the Nikkei’s actual performance and that expected by the model. Those weeks where the Nikkei underperformed were deemed “bullish”; the weeks where the Nikkei did better than expected were “bearish.” I then compared these signals with the performance of the index the following week.
  • There were 410 weeks in which the model delivered a bullish signal. The average performance the following week was +0.26%. There were 394 weeks in which the model delivered a bearish signal. On average, the subsequent week delivered returns of -0.015%. There were 62 weeks in which the Nikkei’s trailing performance was positive but the model expected a loss, as was the case last week. The average return the following week was -0.15%. On a cumulative basis, these divergences are pretty stark.
  • There is of course no guarantee that the negative outlook generated by the model will materialize — after all, it wasn’t designed as a trading tool. Then again, Tuesday’s drop in the Nikkei is exactly the sort of development that this framework “expected.” If you want to figure out where the Nikkei goes from here, you’d do well to keep an eye on the S&P 500 and earnings, as well as USD/JPY.
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